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21. Leasing and Other Asset-Based Financing. Corporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. Cowan. Lease Financing. A lease is a rental agreement that extends for one year or longer.

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21

Leasing and Other Asset-Based Financing

Corporate Financial Management 3e

Emery Finnerty StoweModified for course use by Arnold R. Cowan


Lease Financing

  • A lease is a rental agreement that extends for one year or longer.

  • The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time.

    • In return, the lessee makes fixed periodic payments to the lessor.

  • At termination, the lessee may have the option to either renew the lease or purchase the asset.


Types of Leases

  • Full-service lease

    • Lessor responsible for maintenance, insurance, and property taxes.

  • Net lease

    • Lessee responsible for maintenance, insurance, and property taxes.


Types of Leases

  • Operating lease

    • short-term

    • may be cancelable

  • Financial lease

    • long-term

    • similar to a loan agreement


Types of Lease Financing

  • Direct leases

  • Sale-and-lease-back agreements

  • Leveraged leases


Manufacturer/ Lessor

Lease

Lease

Sale of Asset

Direct Lease

Lessee

or

Manufacturer/ Lessor

Lessee

Lessor


Sale of Asset

Lease

Sale-and-Lease-Back

Lessor

Lessee


Sale of Asset

Manufacturer

Lease

Equity

Lender

Single Purpose Leasing Company

Lien

Lessee

Loan

Equity Investor

Leveraged Lease


Synthetic Leases

  • Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.

  • An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease.

  • Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.


Enron provided some or all of the 3%.

3

2

Lending Group

Partnership or Special Purpose Entity

Enron sells assets, gets debt off the balance sheet and recognizes a gain on the sale.

Enron

Equity Investor

5

4

Enron guarantees the loan. Sometimes with now-worthless Enron shares.

Outside investors inject at least 3% of the funding so that Enron doesn’t have to claim it as a subsidiary.

Enron’s Murky Deals

Enron used outside partnerships to move assets off its balance sheet and monetize assets. But the company was deeply involved with funding those partnerships.

1

Banks provided the other 97% of the financing.


Enron’s Partnerships

  • Reasons for setting up SPEs:

    • By setting up partnerships, partly owned by the company, Enron could draw in capital from outside investors.

    • If structured properly (the tax code requires that at least 3% of the partnership equity be obtained from outside investors), the partnerships could also be kept separate from Enron.


Enron’s Partnerships

  • As a result, any debt incurred by the partnership could be kept off the company's balance sheet.

  • As an added bonus, Enron often recognized a gain on the sale of the assets.


Why did Enron want debt off their balance sheet?

  • The simple answer is that Enron feared that too much debt would damage its credit rating.


Why did Enron want debt off their balance sheet?

  • A more complex answer lies with agency costs. Enron executives headed and partly owned some of the partnerships, which provided a huge source of outside income for those involved.

    • Enron’s former CFO, Andrew Fastow, made more than $30 million from two partnerships that he ran.

  • If you were a shareholder in a SPE buying an asset from your employer, where would your loyalties lie?


How Widespread Was This at Enron?

  • There were hundreds, and perhaps even thousands, of these partnerships.

  • The exact number isn't known.

  • In all, Enron had about 3,500 subsidiaries and affiliates, many of them limited partnerships and limited-liability companies, which are a sort of hybrid between corporations and partnerships.


How Did They Get Away With It?

  • The company and its board of directors claimed that allowing executives to be involved with the outside partnerships gave it the advantage of speed.

  • Enron claimed that it set up safeguards to protect itself, but in retrospect they were clearly inadequate.


Advantages of Leases

  • Efficient use of tax deductions and tax credits of ownership

  • Reduced risk

  • Reduced cost of borrowing

  • Bankruptcy considerations

  • Tapping new sources of funds

  • Circumventing restrictions

    • debt covenants

    • off-balance sheet financing


Disadvantages of Leasing

  • Lessee forfeits tax deductions associated with asset ownership.

  • Lessee usually forgoes residual asset value.


Valuing Financial Leases

  • Basic approach is similar to debt refunding.

  • Lease displaces debt.

  • Missed lease payments can result in the lessor

    • claiming the asset.

    • filing lawsuits.

    • forcing firm into bankruptcy.

  • Risk of a firm’s lease payments are similar to those of its interest and principal payments.


Equivalent Ways to Analyze

  • Net Advantage to Leasing (NAL) approach:

    • Lease if NAL > 0.

  • The Internal Rate of Return (IRR) approach:

    • Lease if IRR of leasing < after-tax cost of debt financing.


Leases Analysis Example

  • The Emerson Co. needs the use of a special purpose stamping machine for the next 10 years.

  • The machine costs $6 million, has a life of 10 years, and a salvage value of $300,000.

  • Emerson can lease this machine from the General Supply Co. for 10 years, with annual year-end lease payments of $1.05 million. Emerson’s tax rate is 40%.


Leases Analysis Example

  • If Emerson were to buy the machine, it would finance 80% of the purchase price with a 11.5% secured installment loan, with the remainder being borrowed as unsecured installment debt at 14% interest.

  • The after-tax required return on the asset is 15%.

  • Evaluate this leasing opportunity.


Leasing Displaces Borrowing

Suppose initially that the Emerson Co. has net assets worth $50 million, and a debt ratio of 50%. Compute the debt ratio if Emerson uses:

  • Conventional financing for the stamping machine.

  • Leases the stamping machine. How would the target debt ratio be restored?


Initial

Capitalization

Conventional Debt

$ 25 M

Financial Lease

Obligation

$ 0

M

Total Debt

$25 M

Equity

$25 M

Total

$50 M

Debt Ratio

50%

Leasing Displaces Borrowing


Conventional

Financing

Conventional Debt

$ 28 M

Financial Lease

Obligation

$ 0

M

Total Debt

$25 M

Equity

$28 M

Total

$56 M

Debt Ratio

50%

Leasing Displaces Borrowing


Lease

Financing

Conventional Debt

$ 2

5 M

Financial Lease

Obligation

$ 6

M

Total Debt

$

31 M

Equity

$25 M

Total

$56 M

Debt Ratio

5

5.36%

Leasing Displaces Borrowing


Debt Ratio

Restored

Conventional Debt

$ 22 M

Financial Lease

Obligation

$ 6 M

Total Debt

$28 M

Equity

$28 M

Total

$56 M

Debt Ratio

50%

Leasing Displaces Borrowing


Analyzing Leases

  • TheNet Advantage to Leasing(NAL) equals the purchase price (P) minus the present value of the incremental after-tax cash flows (CFAT) associated with the lease.

    NAL = P – PV(CFATs)


Analyzing Leases - the Discount Rate

  • The discount rate should be the lessee’s after-tax cost of similarly secured debt.

  • Since the lease obligation is not overcollateralized, the secured debt rate should reflect this.

  • Fully secured means the asset is worth more than 25% of the loan.

    • $80M loan on $100M asset: $20/$80 = 25%

  • Use weighted average of secured and unsecured debt rates if necessary.


Analyzing Leases - the Cash Flows

  • Cost of asset (saving)

  • Lease payments (cost)

  • Incremental differences in operating and other expenses (cost or savings)

  • Depreciation tax shelter (foregone benefit)

  • Expected net residual value (foregone benefit)

  • Investment tax credits (foregone benefit)


Net Advantage to Leasing

Dt= year t depreciation deduction

DEt= year t cash expense savings from leasing

ITC = investment tax credit, if available

CFt = lease payment in year t

N = life of lease (in years)

P = purchase price of asset

r = asset’s after-tax required return

r′ = cost of debt (secured & unsecured)

Salvage = net salvage value

T= lessee’s marginal income tax rate


Net Advantage to Leasing

  • We save paying the purchase price P.

  • We lose the ITC and salvage value.

  • We pay the lease payment CF; this may be partly offset by savings on operating and other cash expenses (E) and by tax deductibility.

  • We lose the depreciation tax shield TD.

  • Discount main cash flows at the after-tax cost of debt.


Net Advantage to Leasing

  • For the Emerson Co.,

    • P = $6 million

    • CFt = $1.05 million per year for 10 years

    • Dt = ($6,000,000 - $300,000) / 10 = $570,000 per year for 10 years

    • DEt = 0, ITC = 0

    • r = 15%

    • r′ = 80%(11.5%) + 20%(14%) = 12.0%


Net Advantage to Leasing


The IRR Approach

  • For Emerson’s leasing opportunity, the IRR is 7.58%.

  • The after-tax cost of debt financing is

    12%×(1– 0.40) = 7.20%.

  • Since the IRR (the cost of lease financing) is greater than the after-tax cost of debt financing, Emerson should not lease the machine.


Break-Even Lease Payments

  • The break-even lease payments can be computed by setting the NAL to zero.

  • In the case of Emerson’s lease, the annual break-even payments are $1,039,206.

    • Since the lease contract calls for payments of $1,050,000; the leasing alternative is not preferred.


NPV of Lease to the Lessor

  • In a perfect market with no tax, leasing is a zero-sum game.

    • The NPV of the lease to the lessor will be

      - (NAL to the lessee).

  • If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game in an otherwise perfect market.


NPV of Lease to the Lessor

where T′ = lessor’s marginal income tax rate.


NPV of Lease to the Lessor


Effect of Tax Asymmetries

  • Suppose lessee’s (Emerson’s) tax rate is zero. Also assume that the before-tax required return on the asset for the lessee is 17.50%.

  • The NAL to Emerson is then $7,460.

  • The NPV to the lessor is still $45,068.

  • Thus, both parties gain from the leasing arrangement.


Tax Treatment of Financial Leases

  • IRS has guidelines for distinguishing between true leases and

    • installment sales agreements.

    • secured loans.

  • If lessor meets these guidelines:

    • lessor can claim tax deductions and credits of asset ownership.

    • lessee can deduct full amount of lease payment for tax purposes.


IRS Guidelines for Financial Leases

  • Term of lease < 80% of asset’s useful life.

  • Lessor must maintain an equity investment of at least 10% of asset’s original cost.

  • Exercise price of the purchase option must equal the asset’s fair market value at the time the option is exercised.

  • Lessee does not pay any portion of the asset’s purchase price.

  • Lessor must hold title to the property.


Accounting Treatment of Financial Leases

  • SFAS 13 requires lessees to capitalize all leases that meet any one of the following:

    • Lease transfers ownership of asset to lessee before the lease expires.

    • Lessee has option to purchase asset at a bargain price.

    • Term of lease is greater than or equal to 75% of assets useful economic life.

    • PV of lease payments is ≥ 90% of asset value.


Project Financing

  • Desirable when

    • Project can stand alone as an economic unit.

    • Project will generate enough revenue (net of operating costs) to service project debt.

  • Examples:

    • Mines & mineral processing facilities

    • Pipelines

    • Oil refineries

    • Paper mills


Project Financing Arrangements

  • Completion undertaking

  • Purchase, throughput, or tolling agreements

  • Cash deficiency agreements


Advantages and Disadvantages of Project Financing

  • Advantages

    • Risk sharing

    • Expanded debt capacity

    • Lower cost of debt

  • Disadvantages

    • Significant transaction costs and legal fees

    • Complex contractual agreements

    • Lenders require a higher yield premium


Limited Partnership Financing

  • Another form of tax-oriented financing.

  • Allows the firm to “sell” the tax deductions and credits associated with asset ownership to the limited partners.

  • Income (or loss) for tax purposes flows through to the partners.

  • Limited partners are passive investors.

  • General partner operates the limited partnership and has unlimited liability.


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